Prepare Yourself for the 10-K Season

We are at this point in time again! The sector of U.S.-listed China stocks has reached new lows, the sentiment couldn't be worse, most longs have been scared away, sitting on the sidelines, and shorts are looking for new trading ideas on a daily basis. The sector has been demonized by a group of self-proclaimed "research firms" nobody has ever heard of before 2010, including Muddy Waters LLC, J Capital or LM Research. And influential financial media like Barron's, TheStreet.com or CNBC are joining the fun by covering the China sector with an almost exclusively negative bias.

This development doesn't come as a surprise, though. As I wrote back in November (Preparing for the RINO Fallout), the downfall of RINO International (RINO) set a precedent of Chinese fraud on the NASDAQ and would likely be exploited to the utmost degree. You can bet your house on the fact that every serious short seller group on the planet spent the month of December digging holes into other Chinese companies' business models and financial statements, and from January on the frequency of new short attacks has increased accordingly. Some of the assaults were pretty laughable (YONG, CAST), while others raise valid points and can not just be shrugged off by investors (CAGC, CEU).

To be clear, there are many companies in the China space that should never have become public. Most have massive transparency issues, many are not entirely truthful about their businesses, and some are outright fraudulent, including several names the market has probably not uncovered yet. There is no doubt that we will see more Chinese stocks following RINO to the pink sheets, go dark entirely, or have to face regulatory pressure incl. SEC investigations, auditor and management resignations, major restatements and lawsuits. Cautious investors who don't have the time or means to dig through those companies' histories, financials and business models, should probably avoid the sector for the time being.

We should appreciate the short sellers' efforts as they help clearing up the space, help to distinguish the quality stocks from those that share similar traits with RINO. Of course this is not their intention - the only thing they want is making money, and we have seen many allegations that were completely unfounded or even based on seemingly manufactured documents - but the outcome will nevertheless be a better environment for investing in U.S.-listed China stocks, as most companies have to go out of their way to prove they are legit, credible and transparent.

Now we are at this point again where the whole group is in an over-correction. Liquidity has dried up, demand is at record lows, fear and uncertainty at record highs. The last time we reached these levels was back in September 2010 when the focus was on stocks like Orient Paper (ONP) and China-Biotics (CHBT). Back then I concluded that "the months-long sell-off in U.S.-listed China stocks has created unreasonable or even ridiculous valuations for many highly profitable high-growth companies, and the market will recognize it as soon as the sentiment changes and big money comes back" (Don't Be Afraid).

Trading China established a Model Portfolio on that day (September 24, 2010), and this portfolio is up 32.18% since, in less than five months. Don't believe anyone who is trying to tell you that there is no money to be made for longs in China stocks, you have the proof right there. Naturally in this environment, not all our positions were winners - we have been wrong at times in the past and we will be wrong with some of our picks in the future. But we surpassed our goal of beating the general U.S. markets with a balanced China portfolio of fundamentally solid picks and speculative growth ideas by a wide margin.

Annual Reports

Should we put our money to work now? Yes and no! Yes only if you have done the kind of extensive diligence that makes you feel comfortable enough in the business model and management, corporate governance and underlying fundamental models and growth prospects of your pick. This is not the time to proceed with a valuation-only approach, it is all about if you can believe the numbers or not. If you haven't done your work then you probably shouldn't invest now, instead use the time to prepare yourself for the upcoming 10-K season. Most China stocks have a regular fiscal year so they are scheduled to file their 10-K's by the end of March. Those annual reports will be audited, and you will see if the auditor signs off on the 2010 numbers, where until now you have only the company's word for how its business was doing.

Here lies both a major risk and an opportunity. Many Chinese companies have announced auditor upgrades late in 2010, mostly to the Big Four, in an attempt to increase transparency and strengthen credibility after the year of turmoil in the space. Those new auditors haven't done much work yet, and their reputation is on the line with the ongoing fraud discussion, a fact I believe those firms are very well aware of. That leads to the assumption that top auditors will run many additional procedures for the full-year audit and won't sign the report quickly. This should be true not only for the Big Four, but also for BDO, Baker Tilly or Crowe Horwath.

The major risk lies in a delayed annual report. Any company that files for an extension without giving a clear time frame will likely see its stock getting destroyed, as the automatic assumption will be that the auditor found severe problems that made it impossible to finish the audit on time. We just have to look back at FUQI or DYP to see the results of a non-filing for investors. Should we get many of those delays we will likely see even more pressure across the entire group of U.S.-listed China stocks.

But if the 10-K is filed on time next month, the 2010 audit completed, the interim quarterly results confirmed, and if no restatements are necessary, then we investors can in fact benefit from the increased pressure on the auditors. A tier one firm that signs off on the numbers of a small cap China stock, in the midst of this "China Fraud" hurricane, is vouching for the accuracy of those financials with their good name. And reputation means everything in this business!

Prepare yourself for the annual reports! If you are using a value-oriented approach to investing, check and double-check the value you see in your company. Don't just go for EPS projections and the like, try to prove that the business model works, use more sources than just your company's filings. Then try to get comfortable with the numbers you find. Do reported profits and margins, projected growth and earnings make sense to you? How do they compare to the industry average, to peers listed on domestic exchanges? What about capital resources, recent financings, does the management seem competent to you? Have there been past issues that are not yet fully resolved?

The bar has to be elevated for China stocks, and if you find several names that you are comfortable with then my approach would be to start building a position in those stocks over the next four weeks on significant dips or general weakness in the sector. But don't use up all your powder as the near term catalyst will be the filing of the annual reports. High-quality, low-valuation stocks that got the green light from their tier one auditor should see significant price appreciation this spring. This is where the big opportunity lies now.

We will make several changes to the China Model Portfolio this weekend.